Is This a 'Deflationary Moment?'

In short, no.

This is what is called a short term liquidity crunch, where traders, in this case most likely hedge funds and small speculators, go into panic selling to address margin calls and short term cash obligations. It is the unwinding of leveraged positions under extreme short term duress. There is some talk that the CDS situation is causing this, and rumours that the banks are forcing the selling by raising short term margin and issuing margin calls, perhaps to an excess.

It is possible to turn this into a deflation, given time and a tightening of the money supply relative to economic growth. The word 'moment' is the tipoff here. There are no 'moments' in a real inflation or a real deflation. They are trends of weeks and months and sometimes years. Short term events, whether due to a storm, the collapse of a company, a panic, are just that: events.

What we are seeing today, almost across the board, is hedge funds selling almost everything to raise cash to meet their obligations. We suspect that the Lehman CDS settlement today may be a precipitant. We are also seeing banks continuing to tighten their lending even to the funds.

It will reach a climax and then things will begin to normalize. VIX is at crash levels today.

For this to become a true 'deflation' would require the world's central banks to start tightening credit, raising interest rates, tightening government budgets. Lets see if they do that. Merely doing nothing would probably not even be enough, since the market would just find a level at which it could clear and then normalize. It takes serious government meddling to create problems like a hyperinflation or a true deflation.

Its important to keep these things square in our minds. Cooler heads prevail, given a little time, and panicking is never a wise strategy, unless you panic first. We're probably beyond that point..


Gold Falls as Dollar Gains, Investors Sell Metal to Raise Cash
By Pham-Duy Nguyen
October 10, 2008 13:09 EDT

Oct. 10 (Bloomberg) -- Gold tumbled from the highest since July as the dollar strengthened and investors sold the metal to cover losses in equity markets. Silver plunged 11 percent.

The dollar headed for the second consecutive weekly gain against a weighted basket of six major currencies. Earlier, gold reached $936.30 an ounce, the highest since July 29, on demand for a haven amid plunging global equity markets.

``Investors are selling gold to raise dollars,'' said Frank McGhee, the head dealer at Integrated Brokerage Services LLC in Chicago. ``It's fear versus dollar strength, and dollar strength is winning...''

Margin Call, Gentlemen?

This is something going around the trading desks. Suddenly tightening margin credit is a precipitant to artificially steep market declines as those students of the Crash of 1929 will well remember. That is something one does on the upside of a potential asset bubble, not in the decline.

If this is true, then there is an obvious need for the Fed to step in and provide credit relief even if on high rates, moreso than propping up a few banks by buying their worthless assets at above market prices.

Forced margin selling because of arbitrary private bank policies is going to create a major problem in the financial markets, leading to a greater concentration of wealth, and the ultimate descent into a loss of freedoms.

The selling has reached historic proportions. There literally is a "run on the market," as investors worldwide are dumping stocks.

It seems that the major catalyst for this selling is the fact that the newest large banks primarily J. P. Morgan, Goldman Sachs, and possibly Morgan Stanley as well -- have issued massive margin calls to hedge funds and other professional traders who use these banks as prime brokers.

These calls were not issued because of market losses, but more because the banks arbitrarily decided that they wanted their customers to use less leverage. Margin rates as low as 15% for broker dealers were raised to 35%; hedge funds who had been used to operating on high leverage were told that they had to bring accounts up to a much larger percentage of equity.

In this illiquid environment, where all manor of exotic securities literally have no bids, the only place to raise the cash to meet margin calls was to sell stock. That is what really set this market over the edge -- as the first notice of these calls were issued on October 2nd and 3rd.

There was something of a grace period to meet the calls, but funds realized they weren't going to be able to meet them other than by selling stock. There are rumors that the most massive of the calls are due Monday (October 13th). If so, this market could continue to decline through then.

Losses on Lehman Brothers Credit Default Swaps Approaching 92 Cents on the Dollar

Lehman default swaps may recover 9.75 pct area
By Karen Brettell
Fri Oct 10, 2008 10:45am EDT

NEW YORK, Oct 10 (Reuters) - Banks, hedge funds and other sellers of protection on Lehman Brothers are facing losses in the area of 91.25 percent of the insurance they sold, based on the initial results of an auction on Friday to determine the value of the credit default swaps.

There are also substantially more sellers than buyers of the debt in the auction, indicating that the final price of the swaps may be even lower than the initial recovery levels of 9.75 percent, according to results published by auction administrators Creditex and Markit.

The net open interest to sell the debt is $4.92 billion, they said.

The auction to settle Lehman's credit default swaps will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman's debt.

Lehman's bankruptcy filing last month sent its bond values plunging as the majority of the investment banking assets that had supported the debt were purchased by Barclays Bank, leaving debt holders at the abandoned holding company with little to reclaim.

Lehman's bonds were trading in the 11 cent on the dollar area on Friday, compared to around 12-to-13 cents on Thursday, according to MarketAxess.

Relative Performance of the SP 500, FTSE and DAX